Why do MBS (mortgage-backed securities) still exist if they created so much trouble in 2008?
Despite their infamous reputation and presumed involvement in the financial crisis of 2007-2008, there are several different arguments in favor of allowing market participants to trade and own mortgage-backed securities (MBS).
At its basic level, an MBS is any investment solution that uses commercial or residential mortgage or a pool of mortgages as the underlying asset. Like most financial innovations, the purpose of an MBS is to increase return and diversify risk. By securitizing pools of similar mortgages, investors can absorb the statistical likelihood of non-payment.
However, an MBS is a complicated instrument and comes in many different forms. It would be difficult to asses the general risk of an MBS, much like it would be difficult to assess the risk of a generic bond or stock. The nature of the underlying asset and the investment contract are large determinants of risk.
Improved Liquidity and Risk Argument
Mortgage debt and pools of mortgages are sold by financial institutions to individual investors, other financial institutions and governments. The money received is used to offer other borrowers loans, including subsidized loans for low-income or at-risk borrowers. In this way, an MBS is a liquid product.
Mortgage-backed securities also reduce risk to the bank. Whenever a bank makes a mortgage loan, it assumes risk of non-payment (default). If it sells the loan, it can transfer risk to the buyer, which is normally an investment bank. The investment bank understands that some mortgages are going to default, so it packages like mortgages into pools. This is similar to how mutual funds operate. In exchange for this risk, investors receive interest payments on the mortgage debt.
Suggesting that these types of MBS are too risky is an argument that could apply to any type of securitization, including bonds and mutual funds.
Aggregate Arguments: Consumption Smoothing and More Homes
Economic research in 2009 suggested that, in both domestic and international markets, the securitization of the mortgage market has led to the sharing of consumption risk. This allows banking institutions to supply credit even during downturns, smoothing out the business cycle and helping normalize interest rates among different populations and risk profiles. Theoretically, the level of consumer spending in the market is smoother and less prone to recession/expansion fluctuations as a result of increased securitization.
The unquestioned result of mortgage securitization has been an increase in home ownership and a reduction in interest rates. Through the MBS and its derivative, the collateralized mortgage obligation, banks have been more able to provide home credit to borrowers who otherwise would have been priced out of the market.
Federal Reserve Involvement
While the MBS market draws a number of negative connotations, the market is more "safe" from an individual investment stand point than it was pre 2008. After the collapse of the housing market, banks, on the back of strict regulation, increased the underwriting standards that have made them more robust and transparent.
The Federal Reserve remains a big player in the MBS market. As at August 2017, the Fed's $4.5 trillion balance sheet consisted of $1.77 trillion in MBS, according to its quarterly report. With the central bank a significant player in the market it has clawed back much of its credibility.
Free to Contract Argument
There is another argument in favor of allowing MBS that has less to do with financial arguments and more to do with the nature of capitalism itself: Capitalism is a profit and loss system, built on the argument that voluntary exchange and individual determination are ultimately preferable to government restrictions. Nobody coerces a borrower into taking out a mortgage loan, just as no financial institution is legally obligated to make additional loans and no investor is forced to purchase an MBS.
The MBS allows investors to seek a return, lets banks reduce risk and gives borrowers the chance to buy homes through free contracts.